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Political and cyclical risk impacts equities

The upcoming UK election brings added uncertainty and risk to the UK equity market. Investor confidence wavers when faced with the likelihood of a coalition of as yet undecided colour. What will it mean for the possibility of an EU exit? How will it impact on the tax status of individuals and employers operating in the UK? What will it mean for future spending on health or on defence?

Political risk is not reserved only for election cycles. Certain sectors and industries are continually at risk of political intervention. For example tobacco, gambling and alcohol are all politically sensitive to name but a few. Regardless of where investors locate themselves on the socially responsible investing spectrum, companies operating in these areas are always at risk of punitive government intervention via regulation and/or taxes. Investors must consider these unknown risks alongside often more readily quantifiable operational issues.

Similarly, where companies are beneficiaries of positive government intervention (think subsidies in the renewable energy, defence and education sectors), investors must consider the possibility that these favourable regulatory regime may not persist. Without this type of government support, the sustainability of many would be called into question.

As always, it is important for investors to make a decision as to which risks genuinely impact the long-term sustainability of a company, and which are more transient in nature. The value of a company, and the price investors should be willing to pay, depends upon the cash flows it is likely to generate over a very long time frame – i.e. one that is likely to see shifts in political favour. However, prices often reflect the current operating environment, and it is this focus on the short term that can provide opportunities.

Commodities are a similar example. Though not political, mining companies are at the mercy of an underlying commodity price that they can’t control, and that is notoriously cyclical (i.e. similar to a political cycle). It is often the case that they are valued by the market depending on the current earnings, and thus the current commodity price. For example, gold miners have seen market prices fall by around 70 per cent over the last 3-4 years as the gold price has retreated from highs in August 2011. This makes sense given the fall in earnings, but might now very significantly undervalue their long term earnings potential.

Providing investors can identify a company strong enough to survive multiple risk cycles (political or otherwise) - and that their investment horizon is equally long-term - it is worth evaluating whether there may be opportunities in companies that are currently facing headwinds, or higher than perceived risks in those with tailwinds.